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SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 210 [Release No. 33-10876; 34-90210; FR-88; IA-5613; IC-34052; File No. S7-26-19] RIN: 3235-AM63 Qualifications of Accountants AGENCY: Securities and Exchange Commission. ACTION: Final rule.

SUMMARY: The Securities and Exchange Commission (“Commission” or “SEC”) is adopting

amendments to update certain auditor independence requirements. These amendments are

intended to more effectively focus the independence analysis on those relationships or services

that are more likely to pose threats to an auditor’s objectivity and impartiality.

DATES: Effective date: [INSERT DATE 180 DAYS AFTER PUBLICATION IN THE

FEDERAL REGISTER].

Compliance dates: See Section II.G for further information on transitioning to the final

amendments.

FOR FURTHER INFORMATION CONTACT: Duc Dang, Senior Special Counsel, or

Natasha Guinan, Chief Counsel, Office of the Chief Accountant, at (202) 551-5300; Alexis

Cunningham, or Jenson Wayne, Assistant Chief Accountants, Chief Accountant’s Office,

Division of Investment Management, at (202) 551-6918, or Pamela K. Ellis, Senior Counsel,

Brian McLaughlin Johnson, Assistant Director, Investment Company Regulation Office, or

Sirimal R. Mukerjee, Branch Chief, Investment Adviser Regulation Office, Division of

Investment Management, at (202) 551-6792, U.S. Securities and Exchange Commission, 100 F

Street NE, Washington, DC 20549.

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SUPPLEMENTARY INFORMATION: We are adopting amendments to 17 CFR 210.2-01

(“Rule 2-01”) of 17 CFR 210.01 et seq. (“Regulation S-X”).1

Table of Contents I. INTRODUCTION .................................................................................................................. 3 II. AMENDMENTS .................................................................................................................... 6

A. Amendments to Definitions ............................................................................................. 6 1. Amendments to the Definitions of Affiliate of the Audit Client and the Investment

Company Complex .......................................................................................................... 6 2. Amendment to the Definition of Audit and Professional Engagement Period .............. 48

B. Amendments to Loans or Debtor-Creditor Relationships ............................................. 53 1. Amendment to Except Student Loans............................................................................ 53 2. Amendment to Clarify the Reference to “A Mortgage Loan” ...................................... 57 3. Amendment to Revise the Credit Card Rule to Refer to “Consumer Loans” ................ 59

C. Amendments to the Business Relationships Rule .......................................................... 62 1. Proposed Amendment to the Reference to “Substantial Stockholder” .......................... 62 2. Comments Received ...................................................................................................... 64 3. Final Amendments ......................................................................................................... 66 4. Conforming Amendments to the Loan Provision .......................................................... 68

D. Amendments for Inadvertent Violations for Mergers and Acquisitions ........................ 69 1. Proposed Amendment .................................................................................................... 69 2. Comments Received ...................................................................................................... 70 3. Final Amendments ......................................................................................................... 74

E. Miscellaneous Amendments .......................................................................................... 79 1. Proposed Miscellaneous Amendments .......................................................................... 79 2. Comments Received ...................................................................................................... 80 3. Final Amendments ......................................................................................................... 80

F. Other Comments Received ............................................................................................ 80 G. Transition ....................................................................................................................... 81

III. OTHER MATTERS.............................................................................................................. 82 IV. ECONOMIC ANALYSIS .................................................................................................... 82

1 Hereinafter, all references to Rule 2-01 and any paragraphs included within the rule refer to Rule 2-01 of

Regulation S-X.

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A. Introduction .................................................................................................................... 82 B. Baseline and Affected Parties ........................................................................................ 84 C. Potential Costs and Benefits .......................................................................................... 89

1. Overall Potential Costs and Benefits ............................................................................. 89 2. Costs and Benefits of Specific Amendments ................................................................. 92 a. Amendments to the Definition of an Affiliate of the Audit Client and Investment

Company Complex ........................................................................................................ 93 b. Amendment to the Definition of Audit and Professional Engagement Period ............ 100 c. Amendments to Loans or Debtor-Creditor Relationships ........................................... 103 d. Amendments to the Business Relationships Rule ....................................................... 104 e. Amendments for Inadvertent Violations for Mergers and Acquisitions ...................... 105

D. Effects on Efficiency, Competition and Capital Formation ......................................... 107 E. Alternatives .................................................................................................................. 109

V. PAPERWORK REDUCTION ACT ................................................................................... 112 VI. FINAL REGULATORY FLEXIBILITY ACT ANALYSIS ............................................. 113

A. Need for, and Objectives of, the Final Amendments ................................................... 113 B. Significant Issues Raised by Public Comment ............................................................ 114 C. Small Entities Subject to the Proposed Rules .............................................................. 114 D. Projected Reporting, Recordkeeping and Other Compliance Requirements ............... 117 E. Agency Action to Minimize Effect on Small Entities ................................................. 119

VII. CODIFICATION UPDATE ............................................................................................... 121 VIII. STATUTORY BASIS ........................................................................................................ 121 I. INTRODUCTION

On December 30, 2019, the Commission proposed amendments to Rule 2-01 to update

certain auditor independence requirements, including by focusing the requirements on those

relationships and services that are more likely to threaten an auditor’s objectivity and impartiality

in light of current market conditions and industry practice.2 Specifically, the Commission

2 Amendments to Rule 2-01, Qualifications of Accountants, Release No. 33-10738, Dec. 30, 2019 [85 FR

2332 (Jan. 15, 2020)] (the “Proposing Release”).

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proposed amendments to the definitions of “affiliate of the audit client,” “investment company

complex,” and “audit and professional engagement period” in Rule 2-01. The Commission also

proposed amending requirements relating to certain loans or debtor-creditor relationships in 17

CFR 210.2-01(c)(1) (“Rule 2-01(c)(1)”) and the reference to “substantial stockholders” in 17

CFR 210.2-01(c)(3) (“Rule 2-01(c)(3)” and the “Business Relationships Rule”). Finally, the

Commission proposed amendments to address inadvertent violations of the independence

requirements as a result of mergers and acquisitions and to make certain miscellaneous updates.

The Commission has long recognized that an audit by an objective, impartial, and skilled

professional contributes to both investor protection and investor confidence.3 If investors do not

perceive that the auditor is independent from the audit client, investors will derive less

confidence from the auditor’s report and the audited financial statements. As such, the

Commission’s auditor independence rule, as set forth in Rule 2-01, requires auditors4 to be

independent of their audit clients both “in fact and in appearance.”5

As the Commission noted in the Proposing Release, except for revisions made in

connection with amendments required by the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley

3 See Revision of the Commission’s Auditor Independence Requirements, Release No. 33-7919 (Nov. 21,

2000) [65 FR 76008 (Dec. 5, 2000)] (“2000 Adopting Release”). 4 We use the terms “accountants” and “auditors” interchangeably in this release. 5 See current Preliminary Note 1 to §210.2-01 and 17 CFR 210.2-01(b) (“Rule 2-01(b)”). See also United

States v. Arthur Young & Co., 465 U.S. 805, 819 n.15 (1984) (“It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation’s financial statements depends upon the public perception of the outside auditor as an independent professional.”).

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Act”)6 and the recent amendments related to certain debtor-creditor relationships,7 many of the

provisions from the 2000 Adopting Release have remained unchanged since adoption. The

amendments we are adopting maintain the bedrock principle that auditors must be independent in

fact and in appearance while improving the relevance of the Commission’s auditor independence

standards in light of existing market conditions by more effectively focusing the independence

analysis on those relationships or services that are more likely8 to threaten an auditor’s

objectivity and impartiality.

Many commenters broadly supported the objectives of the proposed amendments or were

generally in favor of the proposals.9 A few commenters did not support the proposals.10 One of

these commenters expressed the view that the proposals could negatively affect investor

6 See Strengthening the Commission’s Requirements Regarding Auditor Independence, Release No. 33-8183

(Jan. 28, 2003) [68 FR 6005 (Feb. 5, 2003)]. 7 See Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships, Release 33-

10648 (June 18, 2019) [84 FR 32040 (July 5, 2019)] (“Loan Provision Adopting Release”). In this release, references to the “Loan Provision” mean 17 CFR 210.2-01(c)(1)(ii)(A) (“Rule 2-01(c)(1)(ii)(A)”).

8 As compared to the relationships and services that are deemed independence-impairing under existing Rule

2-01, but are unlikely to threaten an auditor’s objectivity and impartiality and would no longer be deemed independence-impairing pursuant to the final amendments.

9 See, e.g., letters from American Investment Council (Mar. 16, 2020) (“AIC”), Investment Company

Institute and Independent Directors Council (Mar. 16, 2020) (“ICI/IDC”), EQT AB (Mar. 13, 2020) (“EQT”), Financial Executives International (Mar. 16, 2020) (“FEI”), Center For Capital Markets Competitiveness – U.S. Chamber of Commerce (Mar. 16, 2020) (“CCMC”), National Association of State Boards of Accountancy (Feb. 25, 2020) (“NASBA”), New York State Society of Certified Public Accountants (Mar. 13, 2020) (“NYSSCPA”), Center for Audit Quality (Mar. 16, 2020) (“CAQ”), American Institute of Certified Public Accountants (Mar. 16, 2020) (“AICPA”), Deloitte LLP (Mar. 4, 2020) (“Deloitte”), BDO USA, LLP (Mar. 10, 2020) (“BDO”), Ernst & Young LLP (Mar. 13, 2020) (“EY”), KPMG LLP (Mar. 13, 2020) (“KPMG”), RSM LLP (Mar. 16, 2020) (“RSM”), PricewaterhouseCoopers LLP (Mar. 16, 2020) (“PwC”), Grant Thornton LLP (Mar. 16, 2020) (“GT”), Crowe LLP (Mar. 16, 2020) (“Crowe”), and William G. Parrett (Mar. 16, 2020) (“Parrett”). The comment letters on the Proposing Release are available at https://www.sec.gov/comments/s7-26-19/s72619.htm.

10 See, e.g., letters from Council of Institutional Investors (Mar. 16, 2020) (“CII”), Consumer Federation of

America (May 4, 2020) (“CFA”), Center for American Progress, et al (May 26, 2020) (“CAP”), and Roy T. Van Brunt (July 23, 2020) (“Van Brunt”).

https://www.sec.gov/comments/s7-26-19/s72619.htm

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protection and capital formation and suggested that, in lieu of the proposals, more should be

done to strengthen auditor independence standards and the enforcement of such standards.11

While commenters were largely supportive of the proposals, we also received

recommendations for modifying or clarifying certain aspects of the proposed amendments. After

reviewing and considering the public comments and recommendations received, we are adopting

the amendments largely as proposed. As we discuss further below, in certain cases we are

adopting the proposed amendments with modifications that are intended to address comments

received.

II. AMENDMENTS

A. Amendments to Definitions

1. Amendments to the Definitions of Affiliate of the Audit Client and the Investment Company Complex

The term “audit client”12 is defined as “the entity whose financial statements or other

information is being audited, reviewed or attested”13 and “any affiliates of the audit client.”14

The current definition of affiliate of the audit client includes, in part, “[a]n entity that

has control over the audit client, or over which the audit client has control, or which is under

common control with the audit client, including the audit client’s parents and subsidiaries” and

11 See letter from CFA. 12 17 CFR 210.2-01(f)(6) (“Rule 2-01(f)(6)”). 13 The term “entity under audit” as used herein and in the final amendments refers to this part of the Rule 2-

01(f)(6) definition of audit client. 14 See Rule 2-01(f)(6). For purposes of 17 CFR 210.2-01(c)(1)(i) (“Rule 2-01(c)(1)(i)”) (Investments in Audit

Clients), entities covered by 17 CFR 210.2-01(f)(4)(ii) (“Rule 2-01(f)(4)(ii)”) or 17 CFR 210.2-01(f)(4)(iii) (“Rule 2-01(f)(4)(iii)”) are not considered affiliates of the audit client, as they are already addressed by 17 CFR 210.2-01(c)(1)(i)(E).

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“[e]ach entity in the investment company complex when the audit client is an entity that is part

of an investment company complex.”15

Under current Rule 2-01, the requirement to identify and monitor for potential

independence-impairing relationships and services applies to affiliated entities, including sister

entities,16 regardless of whether the sister entities are material to the controlling entity.17 This

same requirement to identify and monitor for potential independence-impairing relationships and

services applies to entities, including sister entities that are part of an investment company

complex (“ICC”).18

The Proposing Release noted the challenges in practical application that are associated

with the current definitions of affiliate of the audit client and ICC.19 In particular, the Proposing

Release noted how these definitions can result in relationships with and services to certain sister

entities that are less likely to threaten an auditor’s objectivity and impartiality being deemed

independence-impairing under our rules.20 To address those challenges, the Commission

proposed amendments to the definitions of both affiliate of the audit client and ICC. After

considering the public comments and recommendations received, we are adopting amendments

to both definitions with modifications, as discussed in further detail below.

15 17 CFR 210.2-01(f)(4)(i) (“Rule 2-01(f)(4)(i)”) and 17 CFR 210.2-01(f)(4)(iv) (“Rule 2-01(f)(4)(iv)”). 16 See 17 CFR 210.2-01(f)(4) (“Rule 2-01(f)(4)”) and Rule 2-01(f)(6). We use the term “sister entities” to

refer to entities that are under common control with the entity under audit. 17 See Rule 2-01(f)(4). 18 Id. and 17 CFR 210.2-01(f)(14) (“Rule 2-01(f)(14)”). 19 See Section II.A.1 of the Proposing Release. 20 Id.

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a. Amendments with Respect to Common Control and Affiliate of the Audit Client

i. Proposed Amendments

The Commission proposed amending the definition of an affiliate of the audit client set

forth in Rule 2-01(f)(4)(i) to include a materiality qualifier with respect to operating companies,

including portfolio companies, under common control21 and to clarify the application of this

definition to operating companies and direct auditors of an investment company or investment

adviser or sponsor to the ICC definition.22 In the Proposing Release, the Commission discussed

challenges related to applying the current affiliate of the audit client and ICC definitions,

including challenges related to the limited pool of available qualified auditors, ongoing

monitoring for independence, and related costs.23

Under the proposal, a sister entity would be deemed an affiliate of the audit client “unless

the entity is not material to the controlling entity.” The Proposing Release set forth the

Commission’s view that it is appropriate to exclude sister entities that are not material to the

controlling entity from being considered affiliates of the audit client because an auditor’s

relationships and services with such sister entities do not typically pose a threat to the auditor’s

21 See Proposed Rule 2-01(f)(4)(i)(B). 22 See Proposed Rule 2-01(f)(4)(ii). Specifically, the “and” between the second significant influence

provision would be replaced by an “or.” Consistent with footnote 18 of the Proposing Release, the term “operating company” in this release refers to entities that are not investment companies, investment advisers, or sponsors, and the term “portfolio company” refers to an operating company that has investment companies or unregistered funds in private equity structures among its investors. In Section II.A.1.a of the Proposing Release, the Commission expressed its belief that it would be appropriate to identify the affiliates of the audit client for a portfolio company under audit using the proposed affiliate of the audit client definition, rather than the proposed ICC definition, because portfolio companies are a type of operating company that are often unrelated to each other, even though they are controlled by the same entity in the private equity structure or ICC.

23 See Section II.A.1.a of the Proposing Release.

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objectivity and impartiality and their exclusion would allow auditors and audit clients to focus on

those relationships that are more likely to threaten the auditor’s objectivity and impartiality.

The Proposing Release noted that materiality is applied in the existing affiliate of the

audit client definition in Rules 2-01(f)(4)(ii) and (iii)24 and that the proposed materiality qualifier

would be consistent, in part, with the definition of “affiliate” used by the American Institute of

Certified Public Accountants (“AICPA”) in its ethics and independence rules.25 The AICPA

ethics and independence rules typically apply when domestic companies are not also subject to

the Commission and PCAOB independence requirements. Auditors therefore have experience in

applying a materiality standard when identifying affiliates, whether applying the independence

rules of the Commission or the AICPA.

ii. Comments Received

Commenters generally supported the proposed changes to the definition of the affiliate of

the audit client.26 Consistent with the discussion in the Proposing Release, commenters

24 Rule 2-01(f)(4)(ii) includes as an affiliate of the audit client “an entity over which the audit client has

significant influence, unless the entity is not material to the audit client.” Rule 2-01(f)(4)(iii) includes as an affiliate of the audit client “an entity that has significant influence over the audit client, unless the audit client is not material to the entity.”

25 See AICPA Professional Code of Conduct, available at

https://pub.aicpa.org/codeofconduct/ethicsresources/et-cod.pdf. The Proposing Release acknowledged that the proposed amendment may not result in the same number of sister entities being deemed material to the controlling entity under Commission rules and the AICPA rules. For example, in defining control, the AICPA uses the accounting standards adopted by the Financial Accounting Standards Board (“FASB”), whereas the Commission defines control in Rule 1-02(g) of Regulation S-X. Also, the AICPA affiliate definition pertaining to common control deems a sister entity as an affiliate if the entity under audit and the sister entity are each material to the entity that controls both. The proposed amendment only focused on the materiality of the sister entity to the controlling entity.

26 See e.g., letters from Illinois CPA Society (Feb. 21, 2020) (“Illinois CPA”), SEC Professional Group (Feb.

25, 2020) (“SEC Pro Group”), International Bancshares Corporation (“Mar. 13, 2020”) (“IBC”), NASBA, CAQ, AICPA, Deloitte, BDO, EY, KPMG, RSM, PwC, GT, Crowe, Parrett, AIC, ICI/IDC, EQT, FEI, and CCMC.

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discussed the challenges presented by the current definitions (e.g., cost, difficulty of application,

and impact on the available pool of qualified auditors) and agreed that introducing a materiality

qualifier into the analysis would better focus the analysis on threats to an auditor’s objectivity

and impartiality and address some of those challenges.27

A few commenters opposed the proposed materiality qualifier to the affiliate of the audit

client definition.28 These commenters asserted that introducing a materiality qualifier would

increase the risk that auditors would be performing audits when they are not objective and

impartial, noting that there is evidence that auditors’ materiality judgments vary widely.29 One

of these commenters suggested that the Commission “examine the evidence before changing its

current approach.”30

In addition to these comments on the proposed amendments, we also received feedback

on additional changes to the definition of affiliate of the audit client and other related changes, as

discussed in more detail below.

Comments Recommending a Dual Materiality Threshold

Many commenters recommended that we further amend the common control provision in

the affiliate of the audit client definition to add a materiality qualifier with respect to the entity

27 See e.g., letters from Deloitte, GT, EQT, and CAQ. 28 See e.g., letters from CFA and CII. Both commenters expressed their disagreement regarding the proposed

materiality qualifier within a discussion that covers both the affiliate of the audit client and the ICC definitions.

29 See letters from CFA and CII (citing Katherine Schipper et al., Auditors’ Quantitative Materiality

Judgments: Properties and Implications for Financial Reporting Reliability, 52 J. Acct. Res. 1303 (Dec. 2019), available at https://onlinelibrary.wiley.com/doi/full/10.1111/1475-679X.12286). See infra note 262 and accompanying text.

30 See letter from CFA.

https://onlinelibrary.wiley.com/doi/full/10.1111/1475-679X.12286

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under audit to accompany the proposed materiality qualifier with respect to the sister entity (a

“dual materiality threshold”).31 This dual materiality threshold would result in a sister entity

being deemed an affiliate of the audit client only if the entity under audit and the sister entity are

each material to the controlling entity.32

These commenters stated that, when the entity under audit is not material to the

controlling entity, services provided to or relationships with sister entities typically do not create

threats to an auditor’s objectivity and impartiality.33 For example, one commenter stated that, in

its experience, the entity under audit and the sister entities typically have their own governance

structures, which indicates that there is no mutuality of interest between the auditor and the audit

client.34 Another commenter stated that the proposed single materiality threshold would, in fact,

“increase” the burden on private equity firms by requiring more time and resources to monitor

the “continuously evolving universe of entities that the private firm would need to address…”35

This commenter contended that in the event the entity under audit is not material to the

controlling entity, a dual materiality threshold would alleviate the burdens associated with a

materiality analysis that would otherwise have to be conducted on each sister entity.

31 See e.g., letters from CAQ, AICPA, Deloitte, BDO, EY, KPMG, RSM, PwC, GT, Crowe, Parrett, AIC,

CCMC, New York State Society of Certified Public Accountants (Mar. 13, 2020) (“NYSSCPA”), and Connecticut Society of Certified Public Accountants (Apr. 15, 2020) (“CTCPA”). These commenters noted that analogous provisions exist in the AICPA and the International Ethics Standards Board for Accountants (“IESBA”) ethics and independence requirements.

32 Id. 33 See e.g., letters from BDO, Deloitte, EY, KPMG, PwC, Crowe, CTCPA, CCMC, and GT. 34 See letter from Deloitte. 35 See letter from AIC.

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Commenters also suggested that because a dual materiality threshold is used by the

AICPA and IESBA ethics and independence requirements, adopting a similar threshold would

ease compliance burdens associated with the application of the affiliate definition and on-going

monitoring for audit firms and clients.36 A few commenters noted that any risks associated with

a potential dual materiality threshold would be mitigated by the continued protections afforded

by Rule 2-01(b).37

One commenter that opposed the proposed amendment noted that it also opposed the

“double trigger threshold” of the AICPA.38

Other Comments on Materiality and Monitoring

In response to a request for comment as to whether the proposed amendments should

include a materiality assessment between the entity under audit and sister entities, commenters

generally did not support adding such a provision.39 For example, one commenter stated that

concepts of financial materiality do not lend themselves to an evaluation of relationships

between sister entities, and noted that if one entity had a material investment in the other, the

other provisions of the affiliate of the audit client definition would address such a relationship.40

36 See e.g., letters from CAQ, Deloitte, BDO, RSM, PwC, CCMC, GT, and CTCPA. 37 See e.g., letters from BDO, AICPA, AIC, and EY. 38 See letter from CII. This commenter cited footnote 20 of the Proposing Release and indicated its

agreement that requiring materiality between the entity under audit and the controlling entity may exclude, from the proposed definition, sister entities whose relationships with or services from an auditor would impair the auditor’s objectivity and impartiality.

39 See e.g., letters from Deloitte, KPMG, RSM, and PwC. 40 See letter from KPMG.

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Some commenters suggested that a materiality qualifier also should be applied when

considering whether an entity that has control over the entity under audit (i.e., a controlling

entity) is an affiliate under Rule 2-01(f)(4).41 However, another commenter disagreed, stating

that it believes parents and subsidiaries should continue to be affiliates regardless of

materiality.42

In response to a request for comment as to whether auditors and audit clients would face

challenges in applying the materiality concept in connection with the proposed amendment and

whether additional guidance was needed, some commenters noted that the concept of materiality

already exists within Rule 2-01, and as such, indicated that current materiality guidance is

sufficient.43 By contrast, other commenters suggested that there may be challenges in applying

the materiality concept in connection with the proposed amendments,44 and a few commenters

requested additional guidance or examples.45 One commenter suggested that to ease the burden

of monitoring for compliance in connection with unforeseen changes in circumstances, the

Commission should consider establishing a framework to allow auditors to address “inadvertent

independence violations that might arise when a materiality threshold is crossed.”46

41 See e.g., letters from CAQ, AICPA, Deloitte, BDO, Crowe, CTCPA, and AIC. See also supra 25. The

relevant AICPA definition, 0.400.02, includes as an affiliate “[a]n entity (for example, parent, partnership, or LLC) that controls a financial statement attest client when the financial statement attest client is material to such entity” (emphasis in original).

42 See letter from RSM. 43 See e.g., letters from Deloitte, EY, and Crowe. 44 See e.g., letters from NYSSCPA and PwC. For example, one commenter suggested the Commission define

“controlling entity.” See letter from PwC. 45 See e.g., letters from NYSSCPA, CTCPA, and AIC. 46 See letter from PwC.

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Some commenters suggested that the Commission reiterate the shared responsibility of

audit firms and their audit clients to monitor independence, including monitoring affiliates and

obtaining information necessary to assess materiality.47 One commenter recommended the

Commission clarify that, once the initial materiality assessment has been made, the auditor and

audit client could satisfy their obligations under the proposed amendments by reevaluating

materiality in response to significant transactions, Commission filings, or other information that

become known to the auditor or the audit client through reasonable inquiry.48 Another

commenter requested the Commission discuss expectations regarding best efforts to obtain

information and monitoring if, for example, certain information can only be obtained annually.49

Comments on “Entity under Audit”

In the Proposing Release, the Commission used the term “entity under audit” to describe

the application of the proposed amendments. The Commission explained that it was using this

term to refer to the entity “whose financial statements or other information is being audited,

reviewed or attested.”50 The quoted language is the first clause of the definition of the term

“audit client” in Rule 2-01(f)(6). Because the definition of audit client also includes any

affiliates of the audit client, the Commission used the term “entity under audit” to describe those

entities whose financial statements were subject to audit, review, or attestation, in an attempt to

avoid the potential confusion that may arise from using the term “audit client.”

47 See e.g., letters from CAQ, PwC, and EY. 48 See letter from Deloitte. 49 See letter from GT. 50 See footnote 11 of the Proposing Release and accompanying text.

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In response to this discussion, some commenters suggested that Rule 2-01 incorporate

more precise usage of the terms “audit client” and “entity under audit,” which may require

defining the term “entity under audit.”51 Several of those commenters recommended that the

term “entity under audit” be included in the definition of affiliate of the audit client,52 because

the term “audit client,” which is defined to include affiliates in the definition of affiliate of the

audit client, may cause confusion. One of these commenters characterized the reference to audit

client in the existing affiliate of the audit client definition as a “circular reference.”53

Comments on “Controlling Entity” and “Control”

While we did not propose any amendments to the term “control” as defined in 17 CFR

210.1-02(g) (“Rule 1-02(g)”) of Regulation S-X, a few commenters suggested that, for private

equity firms, the term “controlling entity” should be defined as the overall private equity firm or

the ultimate parent.54 One of these commenters requested further explanation or guidance, such

as through illustrative examples, to address whether the relationship between an investment

adviser and a fund it advises should be treated as a control relationship and suggested that the

term “control” should be linked to the accounting literature.55 While these comments pertained

to entities within an ICC, the comments are relevant when the entity under audit is not an

51 See e.g., letters from AICPA, Deloitte, EY, Crowe, PwC, and GT. 52 See e.g., letters from AICPA, Deloitte, EY, and Crowe. 53 See letter from Crowe. 54 See e.g., letters from PwC and AIC. 55 See letter from PwC.

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investment company or investment adviser or sponsor, but the entity under audit controls or is

controlled by an investment company or investment adviser or sponsor.56

iii. Final Amendments

After considering the public comments and recommendations received, we are adopting

amended 17 CFR 210.2-01(f)(4) (“amended Rule 2-01(f)(4)”) with certain modifications from

the proposal, as described below. We considered the comments received opposing the addition

of materiality to the common control provision, but continue to believe that materiality is an

appropriate principle to effectively focus on relationships with and services provided to sister

entities that are more likely to threaten an auditor’s objectivity and impartiality.

Dual Materiality Threshold

In response to comments, we are modifying the proposed amendments to Rule 2-

01(f)(4)(ii) to incorporate a dual materiality threshold such that a sister entity will be included as

an affiliate of the audit client if the sister entity and the entity under audit are each material to the

controlling entity. Under the final amendments, if either the sister entity or the entity under audit

is not material to the controlling entity, then the sister entity will not be deemed an affiliate of the

audit client pursuant to amended 17 CFR 210.2-01(f)(4)(ii) (“amended Rule 2-01(f)(4)(ii)”).57 In

the Proposing Release, the Commission suggested that requiring that the entity under audit be

material to the controlling entity as part of the proposed definition may exclude sister entities

whose relationships with or services from an auditor would impair the auditor’s objectivity and

impartiality.58 However, after consideration of the comments received and further evaluation,

56 See infra Examples 3 and 4 in Section II.A.1.a.iii. 57 We also are making a technical amendment to renumber the paragraphs within amended Rule 2-01(f)(4). 58 See footnote 20 of the Proposing Release.

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we are persuaded that where the entity under audit is not material to the controlling entity, an

auditor’s relationships with or services provided to sister entities would generally not threaten

the auditor’s objectivity and impartiality. In this regard, we agree that when the entity under

audit is not material to the controlling entity, it is less likely that a mutuality of interest would

develop as a result of relationships with or services provided to sister entities. For example, as

one commenter observed, sister entities with separate governance structures, such as sister

portfolio companies within an ICC, typically lack decision-making capacity over other sister

entities, including an entity under audit.

We also recognize the benefit to auditors, audit clients, and investors of reducing

compliance-related challenges. The adopted dual materiality threshold may help address some

commenters’ concerns about the inability to obtain all relevant information needed to make a

materiality determination with respect to sister entities under the proposed single materiality

threshold. Under the adopted dual materiality threshold, the need to assess the materiality

relationship between the entity under audit and each of the controlling entities should reduce

information access concerns because, in the event the entity under audit is not material to the

controlling entity, the materiality assessment would be made for fewer sister entities as compared

to the proposed single materiality threshold. However, as discussed in Section II.A.1.b.ii below,

the auditor’s non-audit services to and relationships with sister entities that are no longer deemed

affiliates as a result of applying the dual materiality threshold will continue to be subject to the

principles set forth in Rule 2-01(b), and as such, knowledge of services to and relationships with

such non-affiliate sister entities will be needed to sufficiently consider the general standard.

Some commenters also suggested that we incorporate a materiality qualifier in the

evaluation of whether controlling entities would be considered affiliates, similar to analogous

18

provisions in the AICPA and IESBA ethics and independence requirements. While commenters

cited the benefits of having a common regime for the consideration of controlling entities, we

were not persuaded that the benefits from such conformity would justify the potential risk to an

auditor’s objectivity and impartiality in these circumstances. In particular, commenters did not

specifically highlight ongoing monitoring or other compliance challenges associated with the

identification of affiliates that control an entity under audit. It does not appear that the

challenges related to the changing population of potential affiliates and the ability to obtain

appropriate information that occur in the common control context also exist when evaluating

entities that have control over the entity under audit. In addition, the relationship between sister

entities and an entity under audit is generally different than the relationship between a controlling

entity and the entity under audit. The controlling entity typically has some decision-making

ability or an ability to influence the entity under audit. As such, we believe an auditor’s

independence likely would be impaired if the auditor provides non-audit services to or engages

in relationships with the controlling entity that are described in Rule 2-01(c), even in situations in

which the entity under audit is not material to the controlling entity. Accordingly, we are not

adopting commenters’ recommendations to incorporate a materiality qualifier in the evaluation

of whether controlling entities should be considered affiliates.

Entity under Audit

We are making modifications to incorporate the term “entity under audit” within

amended 17 CFR 210.2-01(f)(4)(i) (“amended Rule 2-01(f)(4)(i)”) and amended 17 CFR 210.2-

01(f)(4)(ii) (“amended Rule 2-01(f)(4)(ii)”). Given the comments received on this point and in

light of other changes we are making to the final amendments, we believe it is appropriate to

replace the term “audit client” with “entity under audit” in amended Rules 2-01(f)(4)(i) and (ii).

19

Specifically, as illustrated in the example below, we are concerned that if we do not revise this

terminology, it could be applied in a manner that would negate the adopted dual materiality

threshold.

Figure 1

In Figure 1, assume the controlling entities (i.e., Parent 1 and Hold Co.) have control over

all entities downstream from them. If amended Rules 2-01(f)(4)(i) and (ii) referred to an “audit

client” instead of an “entity under audit,” Sister 1 may be deemed an affiliate of the audit client

regardless of the materiality of Sister 1 or the Entity Under Audit to Parent 1 based on the

following application:

• Parent 1 controls the entity under audit, which makes Parent 1 an affiliate of the audit client.

Parent 1 also is an “audit client” because the definition of such term includes affiliates. A

practitioner might then apply the control provision in amended Rule 2-01(f)(4)(i) to Parent 1

and deem Sister 1 an affiliate of the audit client, regardless of the dual materiality threshold.

The practitioner would consider Sister 1 an affiliate because it is controlled by “audit client”

Parent 1 without applying the materiality analysis in the common control provision of

amended Rule 2-01(f)(4)(ii).

Hold Co.

Parent 1 Entity A

Entity under audit Sister 1 Entity B

20

Similarly, Entities A and B may be deemed affiliates of the audit client regardless of the

materiality of Entity A, Entity B, or the entity under audit to Hold Co. based on the following

application:

• Under the existing and amended rules, Hold Co. is an affiliate of the audit client (i.e., Hold

Co. has control over the entity under audit) and, as such, also is an audit client. A

practitioner might then apply the control provision in amended Rule 2-01(f)(4)(i) to Hold Co.

and deem both Entities A and B as affiliates of the audit client, regardless of the dual

materiality threshold in amended Rule 2-01(f)(4)(ii). Again, the practitioner may deem

Entities A and B to be affiliates because “audit client” Hold Co. controls both Entities A and

B.59

Absent clarification, the above-illustrated application (i.e., circular reading) of the final

amendments could negate the Commission’s objective to focus the common control provision on

those relationships and services that are more likely to threaten the objectivity and impartiality of

an auditor by introducing a dual materiality threshold. While the proposal did not use the term

“entity under audit” in the rule text, we believe this modification is consistent with the proposal

to separate out common control from existing Rule 2-01(f)(4)(i) and include a materiality

provision within the definition. Now that the amended common control provision includes a

dual materiality threshold, we believe the modification to use the term “entity under audit” in

place of the term “audit client” in amended Rules 2-01(f)(4)(i) and (ii) is important to avoid any

59 Relatedly, when assessing whether Entities A and B are affiliates under amended Rule 2-01(f)(4)(ii), it may

otherwise be unclear to a practitioner assessing materiality of the “audit client” whether such assessment applies to the entity under audit or an affiliate (such as Parent 1).

21

misunderstandings about how the common control provision should be applied in the final

amendments.

While some commenters requested that we further amend our rules to incorporate more

precise usage of the term “entity under audit”60 in other paragraphs that currently refer to the

“audit client,” those requests are beyond the scope of this rulemaking. We did not propose or

seek comment on those particular amendments. Moreover, those additional amendments are not

necessary to effectuate any aspect of the proposal. As such, we are not incorporating the term

“entity under audit” into other paragraphs of the rule that currently refer to “audit client,”

including the significant influence provisions of amended 17 CFR 210.2-01(f)(4)(iii) (“amended

Rule 2-01(f)(4)(iii)”) and 17 CFR 210.2-01(f)(4)(iv) (“amended Rule 2-01(f)(4)(iv)”). However,

the incorporation of “entity under audit” in amended Rules 2-01(f)(4)(i) and (ii), while leaving

the term “audit client” within the significant influence provisions in amended Rules 2-

01(f)(4)(iii) and (iv), does not imply a change from the historical practical application of these

provisions, which has focused and should continue to focus on the entity under audit.

Assessing Materiality and Monitoring

Several commenters requested clarification and examples of the application of the

proposed amendments, including the proposed materiality qualifier. In response, we are

providing several examples to illustrate the application of the final amendments to particular fact

patterns.

Auditors and their audit clients have a shared responsibility to monitor independence in

order to satisfy, as applicable, the requirements of the federal securities laws, including Rule 2-

60 See supra note 51.

22

01 and 17 CFR 210.2-02.61 This shared responsibility between auditors and audit clients applies

to all aspects of Rule 2-01, including the final amendments. This responsibility includes the

monitoring of affiliates and obtaining information necessary to assess materiality. We believe

this process works most effectively when management, audit committees, and audit firms work

together to evaluate the auditor’s compliance with the independence rules. For example, auditors

and their audit clients may need to work together to identify and monitor potential affiliates

based on the affiliate of the audit client definition in the independence rules. In this regard, it

will be important for management to notify the auditor in a timely manner of changes in

circumstances that may affect the population of potential affiliates, such as by notifying an

auditor of acquisitions before the acquisitions are effective. Additionally, management should

consider communicating to auditors as early as possible the intent of private companies to file a

registration statement in order for the SEC and PCAOB independence rules to be considered in

advance. Issuers and their audit committees may want to consider having their own policies and

procedures to identify, consider, and monitor the provision of services by and relationships with

the issuer’s independent accountant, which may help supplement the audit firm’s system of

quality control.

The following are intended as illustrative examples only, and practitioners and audit

clients should be aware that an assessment of materiality requires consideration of all relevant

facts and circumstances, including quantitative and qualitative factors.

61 For an overview of the obligations of auditors and audit clients with respect to auditor independence under

the federal securities laws, please see footnote 101 of the Loan Provision Adopting Release.

23

Example 1 – Assessing Materiality of Sister Entities

In this example, Company A, the entity under audit, has five controlling entities, Entities

1 through 5, with Entity 5 as the ultimate parent. Since each of Entities 1 through 5 controls

Company A, directly or indirectly, each of the entities is an affiliate of Company A regardless of

materiality. For purposes of this example, assume that Company A is material to Entity 1 and

Entity 2 and that Company A is not material to Entity 3, Entity 4, or Entity 5. Each of Entities 1

through 5 controls other entities (i.e., sister entities) other than those listed in this example. In

this example, the auditor must evaluate the materiality of the sister entities controlled by each of

Entity 1 and Entity 2 to determine which sister entities are affiliates of the audit client. For a

sister entity controlled by Entity 1, the auditor must assess the materiality of such sister entity to

Entity 5 (Company A is not

material)

Entity 4 (Company A is not

material)

Entity 3 (Company A is not

material)

Entity 2 (Company A is

material)

Entity 1 (Company A is

material)

Company A Entity Under

Audit

24

Entity 1. For a sister entity controlled by Entity 2, the auditor must assess the materiality of that

sister entity to Entity 2.

Example 2 – Controlling and Sister Entities and Monitoring Expectations

Assume the same facts as in Example 1. Company A and the controlling entities should

provide the auditor with sufficient information to enable the auditor to appropriately monitor

controlling entities and identify sister entities, even at the levels of Entities 3 through 5. We

acknowledge the concerns raised by commenters that identifying sister entities that are not

considered affiliates under the final amendments and re-assessing the materiality of the entity

under audit and its sister entities may increase existing compliance burdens. However,

identifying sister entities will be important for complying with the amended rules because there

can be qualitative and quantitative changes that affect the materiality of such relationships, and

audit firms will need to timely address when a sister entity becomes an affiliate. Such

information also will be necessary for an audit firm to appropriately consider and apply Rule 2-

01(b) on an ongoing basis.

After the initial materiality assessment is performed to identify potential affiliates, the

auditor, with the assistance of and information provided by the audit client, should perform

updated assessments based on, among other things, transactions, Commission filings, or other

information that becomes known to the auditor and the audit client through reasonable inquiry.

As a result, obtaining accurate organizational and financial information will be important to the

auditor’s and the audit client’s ability to anticipate and plan for potential changes in materiality

status that may lead to the identification of new affiliates at any point during the audit and

professional engagement period. We understand that this likely will require additional

compliance efforts and believe such efforts and the resultant costs are appropriate to ensure that

25

an auditor is independent from its audit client for purposes of investor protection and investor

confidence. To the extent the final amendments mitigate the compliance challenges associated

with independence violations or prohibitions, or allow an auditor to expand its audit or non-audit

services or relationships, we expect that the auditor will weigh any related benefits against any

additional monitoring and compliance costs. Also, auditors may already be familiar with the

monitoring efforts related to a dual materiality threshold, as the AICPA and IESBA have

analogous provisions. Where an auditor is unable to obtain the information needed to make

reasonable determinations of affiliate status for sister entities, the auditor should treat such sister

entities as affiliates of the audit client for the purpose of the Commission’s independence

requirements to avoid potentially impairing the auditor’s objectivity and impartiality.

The final amendments do not include a transition framework, as requested by a

commenter, to address changes in the materiality of the entity under audit or a sister entity to a

controlling entity. As noted, above, we expect auditors and their clients to be able to anticipate

and plan for changes in materiality and believe this approach fosters an auditor’s objectivity and

impartiality. To the extent that changes in materiality of the entity under audit or sister entities

result in an independence violation, we encourage registrants and accountants to consult with the

Commission’s Office of the Chief Accountant.62

62 See Section II.E.3 and amended introductory paragraph to Rule 2-01.

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Example 3 – Identifying Affiliates of an Entity under Audit that is a Portfolio Company

Company B is the entity under audit and a portfolio company controlled by Fund A.

Fund A is an investment company within an ICC. Company B’s auditor will identify affiliates of

the audit client by applying amended Rules 2-01(f)(4)(i) through (iv). While there are entities

described in the ICC definition that are part of Company B’s organizational structure, including

Fund A and its investment adviser or sponsor, Company B’s auditor, assuming it does not audit

any entity described in the ICC definition, such as Fund A or the Investment Adviser, will not

apply the ICC definition. Company B’s auditor must apply amended Rules 2-01(f)(4)(i) through

(iv) to identify affiliates, which may result in certain investment companies and investment

advisers or sponsors being deemed an affiliate of the audit client.

As noted above, we received a few comments related to the term “controlling entity” and

the term “control,”63 which is defined in Rule 1-02(g). We are not amending Rule 1-02(g) to

link the definition of “control” to the accounting literature as one commenter suggested. We

believe the suggestion to define “controlling entity” solely as the overall private equity firm

when assessing materiality of entities, including a portfolio company, in a private equity

63 See supra note 54.

Investment Adviser

Fund A Other Funds

Company B (Entity under audit)

27

structure64 could raise issues beyond the scope of the proposal that warrant further consideration.

We are therefore not adopting this approach. Under Rule 1-02(g), whether the entity under audit

is a subsidiary of an operating or holding company or a portfolio company within a private

equity structure, all entities that are identified to have control over an entity under audit are

controlling entities.

Example 4 – Application of the Affiliate of the Audit Client Definition When the Entity under Audit Controls Entities within an ICC

Entity X is the entity under audit and is not an investment company, an investment

adviser, or sponsor. Entity X has a subsidiary that serves as an investment adviser to several

investment companies. If the auditor is not engaged to audit the investment company or

investment adviser or sponsor on a standalone basis, the auditor will apply amended Rules 2-

01(f)(4)(i) through (iv) to determine the affiliates of the audit client.

We note that in determining the affiliates of Entity X, in the context of amended Rules 2-

01(f)(4)(i) through (iv), it will be important to consider the relationships between the investment

64 Id.

Entity X (Entity under audit)

Investment Adviser

Investment Companies

Portfolio Companies

28

adviser and the investment companies it advises. Even where an investment company has an

independent board that oversees the investment company’s operations and approves the advisory

contract, the services provided by the investment adviser are generally critical to the

management of day-to-day operations and execution of policies for the investment company.

Therefore, the investment adviser generally will have a controlling relationship over the

investment company for purposes of Rule 1-02(g).

In this example, if the auditor audited Entity X and the investment adviser subsidiary on a

standalone basis, then the auditor would have to apply both amended Rules 2-01(f)(4)(i) through

(iv) as they relate to the audit of Entity X and amended Rule 2-01(f)(14) as it relates to the audit

of the investment adviser.65

b. Proposing Release’s Discussion of Rule 2-01(b)

As noted in the 2000 Adopting Release, “[c]ircumstances that are not specifically set

forth in our rule are measured by the general standard set forth in Rule 2-01(b).” The general

standard includes, in part, that the “Commission will not recognize an accountant as independent,

with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge

of all relevant facts and circumstances would conclude that the accountant is not, capable of

exercising objective and impartial judgment on all issues encompassed within the accountant’s

engagement.”

The Commission explained in the Proposing Release that relationships and services

affected by the proposed amendments to the affiliate of the audit client definition remain subject

to the general independence standard in Rule 2-01(b).66 The Commission also noted that such

65 This is consistent with the discussion and example included in Section II.A.1.b.i of the Proposing Release. 66 See Section II.A.1 of the Proposing Release.

29

relationships and services, individually or in the aggregate, could raise independence concerns

pursuant to the general standard in Rule 2-01(b) due to the nature, extent, relative importance or

other aspects of the service or relationship that may make the service or relationship a threat to

an auditor’s objectivity and impartiality. The Commission indicated that such services or

relationships should be “easily known” due to the nature, extent, relative importance or other

aspects of the services or relationships. Although the Commission did not propose amendments

to Rule 2-01(b), a number of commenters provided feedback on the application of the general

independence standard in light of the proposed amendments.

i. Comments on the Proposing Release’s Discussion of Rule 2-01(b)

Several commenters agreed that relationships and services with entities that would no

longer be deemed affiliates should still be evaluated under Rule 2-01(b).67 However, one

commenter recommended that the Commission consider whether Rule 2-01(b) is sufficient, or

whether further clarification or rulemaking might be appropriate to address situations where

relationships or non-attest services provided to a sister entity that is no longer an affiliate under

the proposed definitions are of a magnitude that “eclipse” the attest services provided within a

private equity or investment company complex.68

A few commenters raised concerns with the Proposing Release’s discussion of Rule 2-

01(b).69 One commenter asserted that the statements were inconsistent with the 2000 Adopting

67 See e.g., letters from Deloitte, EY, KPMG, GT, and Crowe. Some commenters also indicated that the

general standard in Rule 2-01(b) is sufficient to mitigate the risks when relationships and services, individually or in the aggregate, with sister entities that are no longer deemed affiliates under the final amendments could impact an auditor’s objectivity and impartiality. See e.g., letters from Deloitte, EY, and KPMG.

68 See letter from BDO. 69 See e.g., letters from RSM and PwC.

30

Release, which stated that “[c]ircumstances that are not specifically set forth in our rule are

measured by the general standard set forth in Rule 2-01(b)”70 and expressed concern that the

Proposing Release’s discussion of Rule 2-01(b) could be applied more broadly than just to the

entities captured by the affiliate of the audit client definition. Another commenter asserted that it

“may be understood in practice as a change in application and operation of Rule 2-01(b).”71 In

voicing their concerns, these commenters noted that the consideration of Rule 2-01(b) would

reduce the benefits expected to result from the proposed amendments as the auditor would

continue to have to track relationships and services that are being provided to entities that are no

longer affiliates.72

One commenter disagreed with the Proposing Release’s reference to “easily known”

when describing the types of services or relationships that should be evaluated under Rule 2-

01(b) as 17 CFR 210.2-01(c) (“Rule 2-01(c)”) no longer specifically addresses such items.73 A

few commenters asserted that the Proposing Release’s use of “easily known” appears to establish

an expectation of continued monitoring that may reduce the benefits, efficiencies, and cost

savings expected to result from the proposed amendments.74 Two of these commenters

requested further guidance on on-going monitoring obligations if Rule 2-01(b) continues to apply

to non-affiliates and requested the Commission consider clarifying the reference to “easily

70 See letter from RSM (citing to the 2000 Adopting Release at 65 FR 76030). See infra discussion in Section

II.A.1.b.ii. 71 See letter from PwC. 72 See e.g., letters from RSM and PwC. 73 See letter from RSM. 74 See e.g., letters from PwC, RSM, and AIC.

31

known” in the Proposing Release’s discussion of the general standard by utilizing the “knows or

has reason to believe” approach of the AICPA ethics and independence rules.75

ii. Application of Rule 2-01(b) to the Final Amendments

After considering the public comments and recommendations received, we affirm our

view that Rule 2-01(b) applies to those relationships and services that previously were, but are no

longer, covered by Rule 2-01(c) as a result of the final amendments. We do not believe that this

position broadens the scope of the “all relevant facts and circumstances” concept in the general

standard. Nor are we persuaded that this scope should be narrowed in light of the amendments

we are adopting. Otherwise, for example, an auditor could have any number or magnitude of

relationships with or provide services to sister entities that are no longer deemed affiliates under

the final amendments—even where, for example, the importance of such relationships or

services to the auditor and the controlling entity threatens the auditor’s objectivity and

impartiality.

In response to commenters who noted that “easily known” is not a defined term and

requested further explanation, we are clarifying that the types of relationships and services that

must be evaluated under Rule 2-01(b) are those that are known or should be known to the auditor

because of the nature, extent, relative importance or other relevant aspects of the relationships or

services. Consistent with our discussion in Example 2 above, auditors, with the assistance of

their audit clients, are expected to have sufficient information to be able to be aware of and

prepare for changes in materiality that could lead to changes in affiliate status of entities in a

large corporate or ICC structure. As such, we do not expect that identifying and monitoring

75 See letters from PwC and AIC.

32

relationships with and services provided to non-affiliate sister entities that are known or should

be known would require significant additional effort by audit firms. For example, if audit firms

are performing a high volume of services for or have a number of relationships with non-affiliate

sister entities, the audit firm should already know that these relationships exist.

As noted in Section II.A.1.a.iii, the final amendments will more effectively focus the

independence rules and reduce the time and attention that auditors and audit committees spend

avoiding or addressing compliance challenges that arise under the existing rules and should

permit auditors and audit committees to use their resources more effectively to the benefit of

investors. Nothing in the final amendments is intended to change the application of the general

independence standard in Rule 2-01(b). As the Commission noted in the 2000 Adopting Release

and in the rule text for Rule 2-01(c), paragraph (c) is a “non-exclusive” specification of

circumstances. As such, while Rule 2-01(c) enumerates specific circumstances that are

inconsistent with Rule 2-01(b), the general standard of Rule 2-01(b) may encompass

relationships and services that are not otherwise deemed independence-impairing by Rule 2-

01(c).

c. Amendments to the Investment Company Complex Definition

i. Proposed Amendments

The Commission proposed to amend Rule 2-01(f)(4) to clarify that, with respect to an

entity under audit that is an investment company or an investment adviser or sponsor, the auditor

and the audit client should look to proposed Rule 2-01(f)(14) (i.e., the ICC definition) to identify

affiliates of the audit client and not to proposed Rule 2-01(f)(4).76 The Commission also

76 The proposed amendment would replace the existing “and” that appears at the end of existing Rule 2-

01(f)(4)(iii) with an “or” in order to direct auditors of an investment company or an investment adviser or

33

proposed to amend the ICC definition in Rule 2-01(f)(14) to provide additional clarity by

incorporating the term “entity under audit” into Rule 2-01(f)(14) to focus the analysis from the

perspective of the entity under audit and to explicitly define the term “investment company” to

include unregistered funds for the purpose of the ICC definition.77 In the Proposing Release, the

Commission indicated that the proposed amendments were designed to more effectively focus

the independence analysis on the entity under audit, including unregistered funds under audit,

and align that analysis with the independence analysis required for all investment companies.

In addition to the proposed amendments to clarify certain aspects of the ICC definition,

the Commission proposed to include a materiality qualifier in the common control provision of

the ICC definition to align with the proposed amendments to the affiliate of the audit client

definition.78 To further align with the affiliate of the audit client definition, the Commission

proposed including a significant influence provision in the ICC definition.79 Both of these

proposed amendments were meant to provide consistency between the definitions of affiliate of

the audit client and ICC in light of the proposed amendment specifying that auditors of an

sponsor to the ICC definition. In the final amendments, the “or” now appears at the end of amended Rule 2-01(f)(4)(iv) and before amended 17 CFR 210.2-01(f)(4)(v).

77 We use the term “unregistered fund” in this release to refer to entities that are not considered investment

companies pursuant to the exclusions in Section 3(c) of the Investment Company Act of 1940 [15 USC 80a-3(c)].

78 See Proposed Rule 2-01(f)(14)(i)(D)(1). 79 See Proposed Rule 2-01(f)(14)(i)(E). The existing definition of “audit client” in Rule 2-01(f)(6), for the

purpose of Rule 2-01(c)(1)(i), excludes entities that are affiliates only by virtue of the significant influence provisions in existing Rules 2-01(f)(4)(ii) and (iii). To align the treatment of affiliates due to significant influence under proposed Rule 2-01(f)(14)(i)(E) with those in the affiliate of the audit client definition, the Commission proposed an amendment to the “audit client” definition in Rule 2-01(f)(6) to similarly exclude entities identified under proposed Rule 2-01(f)(14)(i)(E).

34

investment company or investment adviser or sponsor would apply proposed Rule 2-01(f)(14) to

identify affiliates of such entity under audit.

The Commission explained in the Proposing Release that while it was introducing a

materiality qualifier in the common control provision, it was retaining within the scope of the

ICC definition any investment company that has an investment adviser or sponsor that is an

affiliate of the audit client—regardless of whether such sister investment companies are material

to the shared investment adviser or sponsor.80

The Commission also noted that while the proposed amendments to the ICC definition

would alter the composition of entities that would be deemed affiliates of the audit client

principally due to a materiality qualifier being added for sister entities, the general independence

standard in Rule 2-01(b) would continue to apply.81 The Commission stated its belief that the

proposed amendments to the ICC definition would provide clarity and address certain

compliance challenges, including challenges related to the number of related entities or the

volume of acquisitions and dispositions in ICCs, and more effectively focus the ICC definition

on those relationships and services that are more likely to threaten auditor objectivity and

impartiality.82

ii. Comments Received

Comments on Overall Approach to ICC Definition

Commenters generally supported the Commission’s proposal to clarify that with respect

to an entity under audit that is an investment company or an investment adviser or sponsor, the

80 See Proposed Rule 2-01(f)(14)(i)(F). 81 See Section II.A.1.b of the Proposing Release. 82 See Section II.A.1 of the Proposing Release.

35

auditor and the audit client should look solely to the ICC definition to identify affiliates of the

audit client,83 and no commenters specifically opposed the proposed approach.

Several commenters expressly agreed with the proposed references to “entity under

audit” in Rule 2-01(f)(14),84 and no commenters specifically opposed the proposed references.

Some commenters supported the Commission’s proposal to include within the meaning

of the term investment company, for the purposes of the ICC definition, entities “that would be

an investment company but for the exclusions provided by Section 3(c) of the Investment

Company Act.”85 For example, one commenter stated that under the current rules, “it was not

clear if unregistered funds would be part of the [ICC] definition, which created uncertainty and

inconsistency in practice.”86 Another commenter stated that, if adopted, the inclusion of

unregistered funds within the ICC definition would enable “the asset management industry

holistically [to] serve the interests of investors and provide for more consistent treatment across

fund businesses.”87 No commenters expressly opposed this proposed amendment.

Many commenters who were supportive of the proposed amendments also requested

clarification on the application of the proposed definitions to specific fact patterns, including the

following circumstances:

83 See e.g., letters from NYSSCPA, CAQ, Deloitte, BDO, EY, KPMG, RSM, GT, Crowe, and ICI/IDC. One

commenter recommended that the final amendments specify that the ICC definition applies when the entity obtains an audit “for SEC reporting or compliance purposes.” See letter from KPMG. We believe this concept is implied by the requirements to apply Rule 2-01 in certain applicable provisions of the Federal securities laws.

84 See e.g., letters from NYSSCPA, Deloitte, BDO, EY, KPMG, and GT. 85 See e.g., letters from Deloitte, EY, KPMG, Crowe, and RSM. 86 See letter from Crowe. 87 See letter from EY.

36

• An investment adviser is the entity under audit and is both an issuer and parent entity;88

• An operating company is the entity under audit and has sister entities that include an

investment company or an investment adviser or sponsor,89 or the operating company

under audit has a subsidiary that is an investment adviser that manages investment

companies;90 and

• The entity under audit is an investment company with sister funds advised by the same

investment adviser, and such sister funds control portfolio companies.91

Regarding other general aspects of the proposed ICC definition, one commenter sought

clarification about whether the reference to investment adviser or sponsor in the proposed ICC

definition also would include custodians.92 A different commenter requested that we revise the

ICC definition to separately address affiliates of an investment company and affiliates of an

investment adviser or sponsor.93

88 See e.g., letters from CAQ and ICI/IDC. Consistent with the discussion in Section II.A.1 of the Proposing

Release, where an auditor is auditing only an investment company or investment adviser or sponsor, such auditor would look to the amended ICC definition to identify affiliates of the audit client. Even where the investment adviser under audit is an issuer and a parent entity, the final amendments dictate that the adviser’s auditor look solely to the amended ICC definition to identify affiliates of the audit client.

89 See e.g., letters from CAQ and Deloitte. The discussion in Section II.A.1.a.iii, above, including Example 3,

illustrates how to apply the amended definitions where an auditor audits only a portfolio company. 90 See letter from EY. The discussion in Section II.A.1.a.iii, above, including Example 4, illustrates how to

apply the amended definitions in response to this circumstance. 91 See e.g., letters from CAQ, BDO, EY, KPMG, Crowe, and AIC. The discussion in Section II.A.1.c.iii,

including Example 5, below, illustrates how to apply the amended definitions in response to this circumstance. One commenter raised a related fact pattern and suggested aligning the proposed amendments with the recent amendments to the Loan Provision. See letter from PwC.

92 See letter from EY; see also infra note 118. 93 See letter from RSM. We do not see a compelling reason to adopt this approach and create separate

provisions for these related entities within an ICC. Additionally, such an approach may be duplicative and add unnecessary complexity to the amended ICC definition.

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Comments on Proposed Rule 2-01(f)(14)(i)(D)(1) – Common Control and Materiality

Many commenters supported the inclusion of a materiality qualifier within proposed Rule

2-01(f)(14)(i)(D)(1), the common control provision of the proposed ICC definition.94 Consistent

with feedback received in response to the proposed materiality qualifier for operating companies

under common control,95 some commenters expressed the view that the materiality qualifier

would not increase the risk to auditor objectivity and impartiality.96 A few commenters,

consistent with their feedback on the affiliate of the audit client definition, also recommended

that proposed Rule 2-01(f)(14)(i)(D)(1) include a dual materiality threshold that would include

consideration of whether the entity under audit is material to the controlling entity.97

However, the two commenters that opposed the proposed materiality qualifier in the

affiliate of the audit client definition also opposed, for similar reasons, the inclusion of such a

qualifier in the proposed ICC amendments.98

While some commenters indicated that auditors would not experience significant

challenges or burdens with assessing materiality in the ICC context,99 other commenters voiced

concerns or noted that additional guidance about the application of materiality would be

helpful.100 Some commenters noted the importance of access to current financial information of

94 See e.g., letters from CAQ, BDO, EY, KPMG, RSM, PwC, GT, Crowe, AIC, ICI/IDC, IBC, CCMC, and

Charles E. Andrews, Audit Committee Chair, Washington Mutual Investors Fund, et al (Mar. 10, 2020) (“Fund AC Chairs”).

95 See Section II.A.1.a.iii. 96 See e.g., letters from EY, RSM, and KPMG. 97 See e.g., letters from EY, AIC, and CCMC. 98 See letters from CII and CFA. 99 See e.g., letters from Fund AC Chairs, EY, and RSM. 100 See e.g., letters from NYSSCPA, GT, RSM, KPMG, PwC and ICI/IDC.

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controlling entities and sister entities for auditors and their clients if the proposed amendments

were adopted.101 In this regard, some commenters requested that the Commission address the

shared responsibility of auditors, their audit clients, and audit committees.102

In response to a request for comment regarding potential application challenges in the

Proposing Release, one commenter indicated there may be challenges in applying the materiality

qualifier because the current definition does not require an assessment of materiality of sister

entities in the context of the ICC.103 The commenter suggested that such challenges could be

addressed by auditors, the Commission, and companies working together to develop consistent

practices and protocols for providing the information needed by auditors to maintain compliance

with the independence rules. Similarly, another commenter requested guidance on the timing

and frequency of monitoring materiality in the ICC context. The commenter suggested the

Commission clarify that, if the sister investment adviser or a fund advised by such sister

investment adviser were not deemed material to the controlling entity after an initial assessment,

then the auditor could satisfy its obligation to monitor materiality on an ongoing basis in

response to significant transactions, SEC filings, or other information that becomes known to the

auditor, or the audit client, through reasonable inquiry.104

101 See e.g., letters from RSM, GT, KPMG, PwC, ICI/IDC, and Fund AC Chairs. 102 See e.g., letters from PwC and EY. 103 See letter from KPMG. 104 See letter from ICI/IDC. See also letters from Deloitte (expressing a similar view as it relates to both Rule

2-01(f)(4) and Rule 2-01(f)(14)) and PwC (suggesting a transition framework to address inadvertent independence violations that arise out of an unexpected change in the population of affiliates for reasons other than a merger or acquisition).

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Under the proposal, auditors and audit clients would have to assess the materiality of

sister entities to their controlling entity even if the sister entities’ investment advisers are not

material to the entity that controls both the sister entities and the entity under audit. In response

to a request for comment regarding whether auditors should have to assess the materiality of

sister investment companies to a controlling entity even where the investment advisers for such

sister investment companies are not material to a controlling entity, commenters generally

thought requiring such assessment would be appropriate to account for instances when a

controlling entity may have an investment in an investment company that would make the

investment company material to the controlling entity even though the investment company’s

adviser is not material to the same controlling entity.105

Comments on Proposed Rule 2-01(f)(14)(i)(F) – Inclusion of Investment Companies Advised or Sponsored by an Affiliate Investment Adviser or Sponsor

In the Proposing Release, the Commission requested comment regarding whether

proposed Rule 2-01(f)(14)(i)(F), which would include within an ICC any investment company

that has any investment adviser or sponsor that is an affiliate of the audit client pursuant to

proposed Rules 2-01(f)(14)(i)(A) through (D), should be adopted. Several commenters

supported the continued inclusion of sister investment companies under proposed Rule 2-

01(f)(14)(i)(F), regardless of the materiality of the sister investment companies once an

investment adviser is deemed to be an affiliate under Rules 2-01(f)(14)(i)(A) through

(f)(14)(i)(D).106 However, one commenter stated that not including a materiality qualifier in

105 See e.g., letters from EY, KPMG, and RSM. One commenter noted that this situation is “not likely to be

common.” See letter from EY. Another commenter requested additional guidance to foster consistent application. See letter from KPMG.

106 See e.g., letters from BDO, EY, KPMG, and ICI/IDC.

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proposed Rule 2-01(f)(14)(i)(F) renders the relief intended by the common control provision in

the proposed ICC definition “inconsequential.”107 Another commenter, while supportive of

proposed Rule 2-01(f)(14)(i)(F), recommended that the reference to proposed Rule 2-

01(f)(14)(i)(D) be removed from proposed Rule 2-01(f)(14)(i)(F) with respect to investment

companies advised by sister investment advisers, because the proposed provision appeared to be

inconsistent with other proposed provisions that would include a materiality qualifier for sister

entity affiliates.108

Comments on Proposed Rule 2-01(f)(14)(i)(E)—the Significant Influence Provision

Some commenters expressly supported the proposed amendment to introduce a

significant influence provision in proposed Rule 2-01(f)(14)(i)(E),109 and no commenters

specifically opposed the proposed amendment. One commenter, while not explicitly supporting

or objecting, recommended that the Commission reiterate the statement from the Loan Provision

Adopting Release that provides guidance on how to apply significant influence in an investment

company context.110

Commenters that addressed this aspect of the proposal also supported the proposed

conforming amendment to Rule 2-01(f)(6) to reference the proposed significant influence

provision in the ICC definition.111

107 See letter from RSM. Specifically, the commenter stated that all entities with a common investment

adviser or sponsor should not automatically be deemed affiliates when other common control entities that are not material to the controlling entity are not deemed affiliates.

108 See letter from KPMG. 109 See e.g., letters from CAQ, BDO, EY, KPMG, and RSM. 110 See letter from ICI/IDC. 111 See e.g., letters from EY, KPMG, and RSM.

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iii. Final Amendments

Overall Approach to ICC Definition

After considering the public comments and recommendations received, we are adopting,

substantially as proposed, amendments to the ICC definition in amended 17 CFR 210.2-01(f)(14)

(“amended Rule 2-01(f)(14)”), with modifications to address the concerns and suggestions raised

by commenters and to align the ICC definition with the final amendment related to the dual

materiality threshold in amended Rule 2-01(f)(4)(ii) discussed above.112

Consistent with the proposal, the final amendments to Rule 2-01(f)(4), the affiliate of the

audit client definition, direct an auditor of an investment company or investment adviser or

sponsor to apply the ICC definition in amended Rule 2-01(f)(14) to identify affiliates. As

proposed, the amended ICC definition uses the term “entity under audit” as the starting point for

the analysis of entities included within the ICC definition.113 We also are adopting as proposed a

definition of “investment company” for the purpose of amended Rule 2-01(f)(14) that includes

unregistered funds.114

112 See Section II.A.1.a.iii. 113 In addition, the final amendments make conforming technical amendments to amended 17 CFR 210.2-

01(f)(14)(i) to incorporate the term “entity under audit.” Using the term “entity under audit” in those subparagraphs alleviate